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Mutual Fund Fakery

Is your expensive, managed fund really an index fund in disguise?

You may be the proud owner of shares of a handful of mutual funds, but unless you're keeping a close watch on them, their managers may be fooling you.

There are a lot of funds out there sporting words such as "growth" and "income" and "capital appreciation" in their names. You could reasonably assume that a fund labeled "income" would be focused on securities such as those that pay hefty dividends. You would likewise be reasonable to assume that a "growth" fund's manager has carefully selected some wonderful businesses with a high potential for rapid growth. But peek under the hood of many such funds and you'll essentially find... an index fund. In other words, these funds tend to contain many or most of the companies in the index they aim to beat -- often in similar proportions.

Index funds, which invest in those companies that make up particular indexes, such as the S&P 500, have long been recommended for most investors by your friends at the Fool. One little investment in an S&P 500 index fund will instantly have you invested in 500 major companies, such as General Electric(NYSE:GE), Verizon(NYSE:VZ), and Merck(NYSE:MRK). You might then think that it's not so bad if some managed funds are like index funds, but you'd be wrong. There are some problems with this situation.

For starters, these "managed" funds (meaning they have managers who actively select holdings instead of just passively copying an index) charge a lot more than the typical index fund. Index funds tend to have lower costs, since management has few decisions to make. ("No change in the index today, boys." "Coach(NYSE:COH)was added to the S&P 500 today, so let's add shares of it pronto.") The Vanguard 500 Index Fund(FUND:VFINX), for example, sports an expense ratio of just 0.18%. That's pretty tiny. Compare that with the Strategic Partners Capital Income Fund M (FUND:IBEIX), which BusinessWeek magazine pointed out as an "expensive index hugger" -- it has an expense ratio of 2.17%. That's just about two full percentage points above the index it copies.

When Fool co-founder David Gardner addressed Congress in 1998 on the subject of mutual fund fees, he explained how much difference a single percentage point can make in a fund's performance:

"Assuming an annual return of 12%, which is not historically unreasonable (although higher than many funds), the initial investment in the DWGF would become $174,000 in 30 years. Not bad. But the cheaper DWGF, with identical performance, would grow to $229,000. That little 1% difference cost the investor more than $50,000, or more than 30%." And that's for just a 1% difference!

So why is this going on with funds? Well, there are several reasons. For one, many funds have grown so big that they find it hard not to spread out their many dollars over most major companies. Also, if they're aiming to beat a certain benchmark index, they'll lower their risk of underperforming it significantly by simply mimicking it, at least to a degree.

Overall, this practice is simply misleading. If you want an index fund, you can go out and invest in one -- very inexpensively, too, if you shop around a mite. If you're paying up for a managed fund, you shouldn't end up with what is sneakily nearly an index fund.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian